What’s the Difference Anyway? Oil and Gas Business Valuation Differentiated

Even for professionals who are well versed in business valuation theories and approaches, valuations in the oil and gas industry offers challenging issues. This article provides a quick review of general valuation approaches and highlights some key characteristics and nuances of oil and gas valuations.

Valuation Approaches

Generally, the most common valuation approaches are:

The Income Approach, which considers the projected expected cash flows of the company. This approach relies on present value of those cash flows, discounted to reflect both time value of money and uncertainty associated with the rate of return from an investment standpoint.

The Underlying Asset Approach, which relies on the market value of assets less the market value of liabilities to value the company at hand. This approach can often incorporate the cost, market, or income approaches for valuation of individual assets on the balance sheet.

The Market Approach, which compares relative prices of similar companies to arrive at a valuation. Generally, the analyst will look for comparable companies based on industry, type, size, etc.

To develop a reasonable and reliable estimate of value, which is the goal of a valuation, a practitioner may use the Income Approach, the Underlying Asset Approach, the Market Approach, or a combination of the three. While each approach has inherent strengths and weaknesses, regardless of the approach used, the practitioner must exercise professional judgment as a methodical application of the general approaches will not necessarily suffice due to some of the more unique characteristics of the oil & gas space.

Key Characteristics and Nuances of Oil and Gas Assets

The oil and gas industry is fraught with complex business relationships. Identifying the correct basis and structure is crucial for valuing a working interest. Further, because the structure affects the firm’s expected future cash flows, it is essential to get this issue correct. The subject asset could be an enterprise, minority equity interest in a field, or a hard asset like the underlying property or reserve. So, identifying the right asset is essential in establishing the proper valuation basis.

Along with identifying the appropriate subject interest, there are three factors that materially affect the valuation of oil and gas reserve interests: (1) the prevailing and future oil prices, (2) the volume produced by wells, and (3) the life of the reserves. All of these factors are critical in determining the value of the reserves and are linked to the corresponding risk of the reserves. As that risk is accounted for in each valuation approach, a practitioner should simultaneously consider the above issues.

Like most commodities, the price of oil is significantly affected by available supply. Any valuation technique that fails to properly account for total production, the rate of production, the relevant time period, and the possibility that the supply may end, will almost certainly produce poor results.

After analyzing the volume and production issues, one must consider the various classifications of oil reserves: Proved, probable, and possible. Proved reserves tend to garner the most attention because they are reserves that are known, but are also the most valuable due to the greater certainty and less risk of yielding cash flow.

Proved reserves (also called “1P reserves”) are further broken down into subgroups, with the most valuable being those that are fully operational and currently producing (called “proved developing producing” or “PDP”), and the least valuable being those that are known but would require up-front capital investment, introducing immediate risk factors, to become functional and producing (called “proved undeveloped” or “PUD”).

Each reserve type has risk factors that need to be accounted for, but generally two methods can be used as part of the valuation. First, the probabilistic method employs a common weighted average cost of capital formula (or “WACC”) across the cash flows from all reserve types, but then discounts based on probabilities of production, i.e. proved, probable, and possible reserves have general production probabilities of 90%, 50%, and 10%, respectively.

The alternative method relies on using various discount rates based on the classification of the reserve (i.e. proved, probable, possible, etc.), and requires sophisticated financial modeling tools and databases. While this method may be viewed as highly precise, it does not always yield an absolutely certain valuation. Valuation is not an exact science, even with highly sophisticated tools at hand.

In Conclusion

Valuing oil and gas assets can present a unique set of challenges to the valuation professional. Practitioners should maintain a basic awareness of the oil and gas industry, and its nuanced terminology, to ensure they understand the specific, underlying interest in the asset to be valued, as well as other factors that can affect the cash flows (primarily the production volume and risk). As mentioned above, valuation is not an absolute science, rather valuation practitioners must apply appropriate judgment to obtain reasonable and reliable results.